China Finally Adopts Market-Based Value for its Currency, But We May Not Like the Results

For years the United States has been complaining that China artificially undervalues its currency, which makes their exports cheaper and gives them a trade advantage over American firms. In response, China has gradually let the renminbi rise. By 2015, it had roughly reached fair market value—though not all American politicians agreed about that.

But then the Chinese economy started going sour. Exports were down. The stock market crashed. Growth slowed. What to do? Answer: devalue the renminbi. But instead of doing it by fiat, pretend that you’re merely responding to market forces:

Every morning, Beijing sets a target for the trading of its currency against the U.S. dollar, then allows investors to buy and sell the currency for 2 percent more or less. Tuesday’s change relaxes the government’s control over setting that rate. The midpoint will now be set at the market’s closing rate for the previous day.

….Now, market forces could pressure the currency to depreciate rather than appreciate, making Chinese products comparatively cheaper….In China, the depreciation will be a boon for exporters and heavy industry, but bad news for companies that depend on imported goods. Shares of Chinese airlines plummeted on Tuesday, as analysts predicted that the higher cost of oil in U.S. dollars would weigh on their earnings.

It’s convenient to have a market-based policy as long as that produces a devaluation of the currency. But will Chinese authorities stick to this policy even when it means the renminbi will appreciate? Good question.

So what does it all mean? Here are a few obvious thoughts:

  • This is yet another vote of no confidence in the Chinese economy. When you put together everything that Chinese authorities have done over the past six months, I’d say they’re close to full-scale panic.
  • Investors are likely to push the renminbi even lower, and this is going to make life harder on anyone in China with dollar-denominated debt. This includes lots of local governments who have been financing the housing boom, which means this devaluation could hasten the housing bust everyone has been waiting for.
  • This will be a political issue in the US, but a tricky one. China is manipulating its currency to its own advantage—boo! hiss!—but has also adopted a policy that allows the renminbi’s value to be dictated by market forces—which is what we’ve been demanding all along. It will be interesting to see how all the Republican presidential candidates decide to respond to this.

Generally speaking, I think this should be taken as bad news. The world economy remains fragile, and if the Chinese economy is falling into recession—as the Chinese themselves seem to believe—it will affect all of us. And not in a good way. Stay tuned.